Effect of Recession on Capital Structure

This report analyzes the effect of the capital structure on the financial performance of an organization during a recession. It explains the adverse effect of recession on the organization's capital structure and describes the influence of the capital structure on the financial performance.

Running head: EFFECT OF RECESSION ON THE CAPITAL STUCTURE
Capital Structure
Name of the Student
Name of the University
Author note

1EFFECT OF RECESSION ON THE CAPITAL STUCTURE
Executive Summary
The aim of the report is to analyse the effect of the capital structure on the financial
performance of an organisation during the time of recession. The primary objective of the
report is to explain the adverse effect of recession on the organisation’s capital structure. The
report also describes the influence of the capital structure in the financial performance of the
organisation.

2EFFECT OF RECESSION ON THE CAPITAL STUCTURE
Table of Contents
Introduction................................................................................................................................3
Review of Literature..................................................................................................................3
Methodology..............................................................................................................................6
Conclusion..................................................................................................................................7
References..................................................................................................................................9

3EFFECT OF RECESSION ON THE CAPITAL STUCTURE
Introduction
The capital structure of a company shows the financing sources applied by the
company for financing the overall financing structure of the company. The capital structure
of the company should be such that allows the application of various sources of financing.
There should be various business factors and macro-economic conditions that should be taken
into consideration for the evaluation of the optimal capital structure of a company. Every
source of financing has its own pros and cons however, the same should be seen from the
business perspective and the business environment under which the operations of the
company is based. The operations and the business environment for a company is not static it
changes as the performance of economy and the level of activity changes in an economy. The
operations of the company also changes with the changing business cycle but it is crucial for
the company to develop strategies and plan which would guide the company in having a
stable business performance. The capital structure of the business is on such key factor
identified that influences the financial performance of a company and the same has been
taken into consideration.
Review of Literature
Capital structure of a company is primarily financed with equity and debt financing,
and the same can be applied in different weights and ratios for supporting the overall
operations and financing activities of the company (Baker & Wurgler, 2015). The debt part
comes from the bond issues or long-term notes payable and the equity part contains the
common stocks, preferred stocks or retained earnings. The capital structure of the company
should not be static and must be in accordance with the changing business and environment
under which it operates. (Vieira, 2017). An optimal capital structure means the capital
consists a balanced proportion of debt and equity. The capital structure depends on the macro

4EFFECT OF RECESSION ON THE CAPITAL STUCTURE
variable factors like the economic growth credit market, bond market and the capital market
(Graham, Leary & Roberts, 2015).
During the recession period, it is found that companies generally reduces the cost of
capital (Matsa, 2018). Earnings of the organisations are volatile and having high financial and
business risk may hurt the sustainable growth rate of the company. The recession period
always, keep the organisations in a dilemma to choose which one to select debt or equity.
Debt financing involves regular and timely payment of interest and principal borrowed by the
company. During the recession period, it is observed that lenders often charge a higher rate of
interest due to the lack of credibility in the market. The capital market also get effected due to
the recession, during the time of recession investors lose their interest in investing in any
company and for that the share price of the companies falls. The capital structure of the
company should be measured in accordance with the impact of the same on the financial
position and financial performance of the company (Fernando,et al 2015).
The profitability of the organisation decreases during the recession period whereby
the companies will not try to increase borrowings, indicating that the companies will try to
pull down the percentage of debt from the capital structure so that the profit percentage
remain sustainable during the recession period. Sustainability in the financial performance of
the company is a key measure which can be well addressed with the various strategies and
ideas implemented by the management of the company. The debt part of the capital structure
gives the benefit of tax savings to the organisation (Zaman,et al, 2018). However, excessive
debt in the capital structure also become risky during financial crisis in the economy (Pontoh,
2017). The earning capacity falls during the recession period for which the company fails to
repay the debt obligation (DeAngelo, & Stulz, 2015). The choice of capital structure effects
on the performance of the organisation, the relation between capital structure and recession
period is explained, it is found that there is a negative relation between the firm’s capital

5EFFECT OF RECESSION ON THE CAPITAL STUCTURE
structure and recession. The performance of highly leveraged firms during the period of
financial crisis is poor in comparison to the firms, which have less debt in its capital structure
(Herranz, Krasa, & Villamil, 2015).
The recession period puts a mixed impact on the choice of capital structure of the
organisation. It has been observed that equity financing would be preferred rather than equity
financing because of the nature of finance structure. The recession does not put any
significant effect on the long term financing of the firm but it effects the short-term debt
(Haw, et al 2015).
It has been observed that during the time of recession the firms try to hedge the risk of
debt by retaining more cash and by issuing more equity. The equity part does not contain risk
and for that reason, the firms prefer to issue more equity during the time of financial crisis.
The financial crisis puts a mixed impact on the capital structure as well as on the performance
of the organisation (Østhus, &Torstensen, 2018). The recession period reduces the earning
capacity of the firm, which effects the share price of the company. The financial performance
of the company is influenced by the strategy and level of business done by the company
however, the company in addition to the same should also defined the strategic goals and
objectives. Companies should adhere to the financial policies so that the operations and the
goals of the companies remains unaffected.
Therefore, the effect of the recession brings mixed effect on the capital structure of
the firm. The firms generally depends on the internal funding during the recession period and
the not on the external factors for raising funds. The debt instruments like bonds long-term
loans short-term loans become more risky during the recession period, which creates negative
impact on the performance of the organisations. On the other hand, internal sources of
funding like equity and retained earnings become the major instruments for the companies to

6EFFECT OF RECESSION ON THE CAPITAL STUCTURE
prevent the adverse effect of recession on the business environment. The internal source of
finance give support to the firms to continue their operations, by providing the required
working capital requirement of the firm. These benefits of the equity capital has made it
attractive for the organisations to raise more equity capital during the period of financial
crisis.
Methodology
The weighted average cost of capital can be derived with the help of the formula
WACC: {(Weight of Equity*Cost of Equity) +Weight of Debt*Cost of Debt*(1-Tax rate)}.
The above formula is applied for determining the optimal capital structure of the company.
The cost of equity can be derived with the help of the Capital Asset Pricing Model which
takes the beta of the stock and the return on market as the key components for developing the
same. The formula applied for deriving the Cost of Equity and Cost of Debt is:
Cost of Equity [K (E)]: Risk free rate of return (Rf) + [Beta*(Return on Market- Risk free
rate of return)].
Cost of Debt [K (d)]: (Interest Paid/Long Term Liabilities)*(1- Tax Rate).
The cost of equity is generally higher and it reflects the minimum required return by
the equity shareholders of the company on the invested capital and for taking the risks
associated with the company. However, on the other hand side the cost of debt for the
company is generally lower for the company and additionally provides a tax shield on the
interest paid by the company which ultimately leaves the company with a higher amount of
wealth. The low cost debt financing comes with a financial risk of the company which
implies that irrespective of the business conditions and environment the company has to
timely pay its interest and principal on time.

7EFFECT OF RECESSION ON THE CAPITAL STUCTURE
There are various other model and theories like the pecking order theory which shows
the sources of financing which the company should apply in its capital structure so that the
financial performance of the company stays stable. The theory gives first priority to internal
funds at the priority level than application of debt financing and at the final stage to the
equity financing. The theory gives importance to the different financing sources in
accordance with the costs associated with each of the following.
The Modigliani and miller (1958) opposed the traditional concept of capital structure
by only taking debt and equity financing as the only source and having a constant amount
throughout the level of operations of the business. The M&M approach says that an optimal
capital structure for a firm does not exist rather they are based on certain assumptions and the
same has no effect on the value of firm. Equity in the one hand side is considered to be a
safer financing source as it does not creates a charge on the assets of the company and the
same does not adds any additional risk in the overall risk structure of the company. It has
been observed that the organisations, which have issued more equity during the recession
period, has been able to perform better than firms preferring debt financing (Berger, Chen &
Li, 2018).
The trade-off theory on the other hand is the other key theory which explains that the
firms trade of the cost and benefit arising from the equity and debt financing after taking
several factors like market imperfections, conditions and several other costs for finding there
optimal capital structure. Debt financing becomes more risky for the company at the time of
recession when the profitability of the company and the level of activity undertaken by the
company is relatively less. The level of profitability is lower where high amount of interest
payment can destroy the returns of equity shareholders and make the company report
significantly lower profit. (Gertler, & Gilchrist, 2018).

8EFFECT OF RECESSION ON THE CAPITAL STUCTURE
Conclusion
The above report explained about the various sources of capital structure and the
implication of the same on the operations of the company. The capital structure of the
company should not be static rather that it should consider the various scenarios and
conditions that can significantly affect the financial position and the performance of the
company. Thus, it is essential that the companies should have a suitable and an optimal
capital structure that does not affect the financial performance of the company.

9EFFECT OF RECESSION ON THE CAPITAL STUCTURE
References
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capital. Feng, Firm Specific Information and the Cost of Equity Capital (April 2,
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Herranz, N., Krasa, S., & Villamil, A. P. (2015). Entrepreneurs, risk aversion, and dynamic
firms. Journal of Political Economy, 123(5), 1133-1176.

10EFFECT OF RECESSION ON THE CAPITAL STUCTURE
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